How Will Basel III Impact Community Banks?

In January, when the Basel Committee on Banking Supervision approved a final rule regarding Basel III regulations, U.S. small banks were mostly unimpressed. Although the decision delayed the implementation of the rules, and made the capital requirements less strict than an earlier draft version of Basel III, community bankers say they are dissatisfied with the mortgage-related components of the proposed regulations.

‘The announcement was primarily surrounding the liquidity standards, and those do not apply to many community banks,’ says Bill Loving, president and CEO of Pendleton Community Bank, based in Franklin, W.Va. ‘They apply to the systemically important financial institutions.’
Loving adds that community banks are more concerned with the rules regarding risk weighting. ‘That's the area that will have the most significance,’ he says.

The proposed risk weighting will classify mortgages into Category 1 or Category 2. Category 1 mortgages are mostly 30-year mortgages that are first mortgages that do not have balloon payments. Category 2 includes second mortgages and balloon mortgages. Category 2 has higher risk weights, and balloon mortgages automatically go to Category 2, a factor that Loving thinks is punitive to community banks.

‘Many community banks write balloon mortgages that have three-year, five-year and seven-year balloons because many community banks cannot hold long-term fixed-rate mortgages on their books,’ Loving says. ‘Probably, there were some balloon mortgages by bad players, but balloon mortgages themselves are not bad instruments. We have been writing them for years.’

Instead of applying these complex requirements to community banks, there should be tiered regulations, Loving says. ‘Community banking is relationship banking. We know our customers, we know where they live, we know how much money they make.’

The rules might make sense for large banks, a point that Loving made with legislators last year. In November, Loving, who is also chairman-elect of the Washington, D.C.-based Independent Community Bankers of America (ICBA), testified before the House Financial Services Subcommittees on Insurance, Housing and Community Opportunity and on Financial Institutions and Consumer Credit. He asked that policymakers exempt community banks from the Basel III guidelines, or at least modify the rules. Among the ICBA's suggested modifications are to fully exempt banks with under $50 billion in assets from the standardized approach for risk-weighted assets, and to reduce the higher risk weights for balloon mortgages and second mortgages to their current Basel I levels.

Christopher Cole, senior vice president and senior regulatory counsel for the ICBA, says regulators seemed open to the idea of not blaming community banks for the financial crisis.

‘A lot of senators and congressmen were on our side,’ Cole says. ‘They asked questions on why are you extending this to community banks. We were not the cause of the problem. Regulators really got a tongue lashing.’

The risk weighting also factors in the loan-to-value (LTV) ratio, further complicating the rules. From an operations standpoint, that would call for more reporting, more software upgrades, and more work for small banks, Cole says.
The Basel Committee included representatives from 26 countries, and although the rules are not binding on the countries, the governments represented on the committee generally comply with the rules. U.S. regulators are still reviewing Basel III and will likely make an announcement this spring.

The Basel III rules do not affect credit unions. Nonetheless, Carrie Hunt, general counsel and vice president of regulatory affairs for the National Association of Federal Credit Unions, is keeping an eye on them.

‘We sympathize with small banks,’ she says. ‘You cannot have a one-size-fits-all approach. There is concern that the rules are overly complex, and for smaller lenders, it is problematic.’

Hunt adds that it is hard to speculate on whether certain rules concerning credit unions and mortgages would change as a ripple effect of Basel III, but there might be some changes.

‘Regulators like to create some uniformity in the market,’ Hunt says. ‘We are concerned with anything that inhibits institutions' ability to lend, especially at this time when we are trying to get the housing market back to health.’

Cole is optimistic that community banks will get exemptions from some of the rules.

‘I think there is consensus among regulators that capital requirements need to go up, and we don't have a problem with that,’ he says. ‘We have a problem with the presumption that all balloon mortgages are risky.’

Nora Caley is a Denver-based freelance writer. She can be reached at


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